Takeaway: Money exists in the form of financial sector and real economy money. Real world money is created through credit by the government and commercial banks, and the central banks have little to do with it.
This is a long, but important one.
Much has been written on money printing, yet there has rarely been an more important subject so poorly investigated.
I will break it down for you. How money and banking works today.
Money could be categorized into two types: (a) financial and interbank money and (b) private sector money.
Financial sector money (explained in another post) can only be used in the financial system, whereas real economy money is used by people, businesses, and governments.
So let’s focus on real economy money. There are two main ways in which it is created.
1. By the government when it issues more debt than money it collects (runs a net deficit).
2. By commercial banks when they issues loans (including mortgages).
Let me explain exactly how that happens.
Scenario 1. The government increases its account at the central bank. The Government money is first created by increasing the Treasury General Account (the governments accounts at the central bank).
The government then spends that money and puts it into the private sector’s hands. The private sector deposits it at commercial banks, increasing total deposits. At this point in time, the newly created deposits are likely backed by central bank reserves.
Subsequently, the government sells government debt at auctions, where primary dealers (often branches of commercial banks) are obliged to bid for those instruments. The commercial banks then typically buy those and replace the central bank reserves with the government debt that was issued. The reason they do this is because high quality government debt is usually more useful to them than central bank reserves, as it can be used in various financial operations (such as short-term lending i.e. repurchasing agreements).
This deposit is first represented on the asset side of the commercial bank as cash / reserves at the central bank, but eventually more often is swapped for a similar government debt instrument like the one that led to the creation of the deposit. Because government debt is a regulatory-friendly high-quality asset, it is overwhelmingly used by the commercial bank as a contra account to deposits – which could include the one it just helped create.
The role of the central bank is a purely facilitatory one. By creating sufficient central bank reserves in advance of government money printing, they can dampen their impact on the banking system by managing the timing gap between when the money is created (and subsequent deposits), and the government debt (high quality collateral) is available to buy by the commercial banks to cover the asset side seen in the graph above.
Therefore, if the government runs a deficit, it has on a net basis created new money. Reduction of deficits through e.g. taxes improve that deficit and destroy money.
Scenario 2. A commercial bank issues a loan.
Let’s first consider a normal non-bank lending process:
If a non-bank has a balance sheet of $200 cash |$200 equity and issues a loan of $100, that 100 is paid out of cash to a borrower. Now the company has a $100 loan receivable, $100 cash | $200 equity. On a net basis, the balance sheet change = $0 and cash is -$100.
The borrower on the other hand has $100 cash | $100 loan payable. The net change in their cash balance is +$100.
However, since the lender has now -$100 cash in their accounts, no money has been created.
How banks create money:
The important thing to understand is that money is really about balance sheet capacity. Besides the few notes and coins in circulation, real economy money exists primarily in the accounting books of banks (and increasingly also in Money Market Funds).
Real economy money = balance sheet capacity of banks
This stylized balance sheet will help us explain. Visualised here are all banks in a country as one single bank. The sizes are approx. proportionate to the total US banking sectors’ balance sheet …
Looking at the reserves / cash section and comparing it to the deposits, may lead people to the conclusion that banks have only a fraction of their deposits in cash or reserves at the central bank. That is true, but a more accurate way to describe it is that your deposits are backed by different assets that can be turned into money. The problem with the ‘fractional reserve’ view is that it perpetuates the belief that the rest of the money you deposited is lent out. However, that is not the case.
Contrary to the way a non-bank lends money – which results in no increase in net money, banks create net new money.
The reason this is so complicated is because the nature of the deposit defies normal accounting logic. The complication occurs because exclusively for banks, deposits stem from two different business activities. On one hand, banks are deposit-taking institutions – your (cash) asset is their liability. On the other hand, they create loans: booking a loan receivable on the asset side, and a loan payable on the liabilities side. They then reclassify the loan payable into a customer deposit.
Bank deposit = loan liability (loan given by you to the bank)
What makes this possible is the fact that banks are exempt from client money rules. In short, this means they do not need to segregate customer funds from their balance sheet. This is evident from the diagram above. This license allows them to incur a liability upon themselves, i.e. turn the loan payable into a customer deposit – something no one else can do. For example, when a bank issues a loan (see graphic below), it records a loan receivable as an asset and a fictional loan payable as a liability. It can be thought of as the liability being switched into a deposit.
This is how it looks like when a bank issues a loan to someone:
The deposit is invented at the push of a bookkeeper’s finger.
If the person spends the loan, it essentially gets transacted to another depositor, leading to no change in total deposits until the loan is repaid.
In the event the loan is repaid, the loan receivable is repaid and therewith destroyed. The money with which the loan is repaid also disappears from the deposit side of the balance sheet. In the same way money is created by issuing a loan, money is destroyed by repaying the loan.
Wait, if banks and governments create money through credit, could they create unlimited amounts of money!?
Well… no, not quite.
Constraints to money printing
1. Governments are limited by the self-imposed debt ceiling, credibility, and demand.
If the government prints too much money (debt) compared to its economic output, it risks losing its credibility. A loss of confidence in the debt of these governments can lead to the rejection of government debt, leading to the destruction of the system.
2. Banks are limited by regulation and profit maximisation.
Extending loans that have a poor risk/reward profile deteriorates the profit of the bank. Banks are always at the risk of losing some of their deposits they have created through loans due to shifting deposits to other banks, failure to repay, or cash withdrawals. This profit-seeking mechanism constraines banks' credit creation.
We expand on the three most relevant regulatory ones:
Basel III Capital Requirements
The capital adequacy ratio is a measure of a bank's available capital (tier 1 and 2) in comparison to its risk-weighted assets. Its purpose is to ensure that the bank’s owners (equity and debt holders) can stem the losses in the loan portfolio of the bank and that depositors are not hit by a decline in those assets).
A liquidity coverage ratio (LCR) makes sure that the bank can stem unexpected rapid outflows by monitoring for example its highly liquid assets / expected cash monthly outflows.
The reserve requirement is set by the central bank, usually 0-10% of reservable liabilities of the commercial banks, although usually its 0%.
As you can see by the explanations of the regulatory requirements – the problem is that the regulation is really made for a different kind of banking system: one where banks serve as pure intermediaries and replicators of fractional reserves, reinforcing the prevalent fractional reserve and intermediation theories of banking.
No deposit is ever paid out as a loan. The banks do not lend money, they create it.
Recognition of the credit creation theory
You see, on top of the confusing exemption to some accounting rules, these requirements can easily lead casual observers to the false conclusion that banks are pure intermediaries and lend out money based on fractional reserves.
Why is this not widely recognised?
Well admittedly, it is complicated. From generation to generation, economists seem to alternate between the financial intermediation, fractional reserve, and credit creation theory. Yet only the credit creation theory has ever been empirically proven.
There are certainly other reasons which we will not expand upon too much. Historically the money creation mechanisms have been poorly documented and investigated. Most economists have swayed between different theories, never clearly taking a position on how money is created, and have often muddled the waters with contradicting generalisations.
Why that is so, is not straightforward.
Reasons may be the difficulty to empirically prove the theories due to the highly guarded accounting functions of banks, or there may be intent in not divulging the inner workings of money creation. I think the biggest reason – and this is what we can observe throughout history – is that the banking and money creation process evolved by trying new things, i.e. the creativity and greed of bankers. It was not through centralised planning of how banking and money should work. It just kind of evolved and we created rules around it to contain its systemic risk. Hence, few can cohesively explain money creation and flows.
Central banks may also have intentional, perhaps subconscious incentive to enhance the psychological effectiveness of their policy decisions. This could be done by perpetuating the belief that QE is very simply printing money and there is no more complexity to it. To that end, two FED chairmen have gone on 60 Minutes; Jerome Powell in 2021 and Bernanke in the depths of the 2009 crisis – a PR move. Whereas revealing the complexities of government and commercial banks creating money could expose a fragility to the system they try to control.
Nonetheless, central banks do have powerful tools at their disposal to backstop the markets, particularly by acting as lender of last resort; however, real money printing is not one of them.
Whatever the reasons are, we have hopefully provided clarity and some food for thought.
How money is created through credit is crucial to understand when we look at liquidity, QE, and the possible implications of a CBDC.